Week Ahead: Is the Sun Setting on the Market Rally?

The twilight week of summer could provide some new clues about the strength of the stock market's rally after Labor Day.

Ask any trader, and the conventional wisdom you hear will be to expect a quiet week, but watch out after Labor Day when Wall Street gets back to work. Still, there's a heavy calendar of important economic data this week that will show more detail about the strength of the economic recovery.

Oliver Quillia for CNBC.com

A New York Stock Exchange trader.

August's employment report Friday will be the big headline for markets. There are also other key reports, including the ISM manufacturing and non-manufacturing surveys, minutes form the last Fed meeting, monthly auto sales and the Chicago Purchasing Managers report.

The Dow in the past week rose just 0.4 percent to 9544, its sixth gain in seven weeks. The Dow is now up 4.1 percent for the month, so far its best August in nine years. The S&P 500 was up just 0.2 percent for the week to 1028, and is on track for a 4.2 percent monthly gain, also the best August since 2000.

The dollar was fractionally higher on the week against a basket of currencies. It was down 0.3 percent against the euro, at $1.4302. Treasurys held their ground, and commodities were mostly higher.

"In the next two weeks, things are going to change for stocks and bonds rather dramatically, and one of those has it wrong," said David Ader, head of Treasury strategy at CRT Capital. "It's the data we're going to get in the next couple of weeks—this second set of third quarter data that is going to start showing how things are going one way or the other."

There is little corporate earnings news to propel stocks, and the markets will focus instead on the stream of manufacturing, jobs and other data.

Citigroup chief U.S. equities strategist Tobias Levkovich is one of those expecting stocks to pull back in the fall. His year end target for the S&P is 1000, slightly below the current level.

One reason he expects a sell off is that investors will begin to look ahead to the next year, and as of now, earnings estimates for 2010 are too high. Levkovich expects bottom up earnings for the S&P 500 to increase 13.3 percent over 2009, but the street consensus is nearly double that level.

"This time of year you tend to get a lot more focus on the coming year, and as you get into the third quarter reporting time frame, you also tend to get a lot more management guidance," said Levkovich. He expects third quarter earnings to be "decent," showing benefits from production increases and cost cutting.

He said another problem for the market in the fall could be the resumption of the health care reform debate in Washington. "How is that going to be funded? We sat back at the end of July and said we expect problems to emerging into the September-October time frame, and we're not backing away from that general view," Levkovich said.

"We're not talking about a return to March or anything like that, or the fears of last November following Lehman's collapse, but some correction is probably a good thing in a weird way. You consolidate some of the gains instead of overshooting really badly and instead of suffering bigger losses as people get sucked in at higher prices," said Levkovich.

Traders also say the large amount of cash that has stayed out of the market could act as a cushion against losses, as fund managers take advantage of dips to put money into stocks. "Consensus is that we're not going to get any more money into the market until the market pulls back," said Art Hogan of Jefferies. "Everybody we talk to is of the same mind set. Typically when that happens, you don't get the pull back."

"One thing about next week is people are going to make excuses about prices, no matter what happens, and blame it on volume," said Pimco market strategist Tony Crescenzi. Stocks have rallied on low volume, a concern for analysts who say the market's move lacks conviction.

However, traders have been concerned that on several days in the past week, market volume was dominated by heavy trading in low quality financial names, like Fannie Mae , Citigroup , AIG and Freddie Mac . "If you took the top traded stocks and gave them normal volumes, overall volume would be down 30 percent," said Hogan.

Payroll Loss Predictions

Econorama

As the debate rages about whether the stock market is topping out, there is the parallel debate about the shape of the economic recovery. Economists mostly expect the third quarter to show positive growth, driven by a pickup in production as industry looks to rebuild inventories.

The view that this activity will lead to broader recovery has helped drive stocks higher, giving the S&P 500 a more 50 percent plus gain since early March. But now a common view is that some of those gains will evaporate because the recovery is not keeping up with the stock market. There is also concern that the economy could double dip.

"There seems to be a prevailing thought that there's something worse behind the the inventory led rebound and the fiscal led rebound," said Tony Crescenzi, market strategist with Pimco.

Jobs are one of the most important data points to watch. Although employment is a lagging indicator, the declines need to subside before the economy can recover. Weekly unemployment claims have stalled out recently in terms of showing improvement, signaling some analysts that the recovery could be slower than they expected.

"The claims level suggests losses of over 300,000," in non-farm payrolls, said Crescenzi. Consensus is that 230,000 jobs were lost in August.

ISM is also important this week. It is expected to rise above 50, signaling a growing economy for the first time in months.

In the coming week, Chicago purchasing managers data is reported Monday. ISM manufacturing is Tuesday, as are pending home sales, construction spending, auto sales, and the Fed's minutes. On Wednesday, ADP's employment report, productivity and costs and factory orders are reported. Weekly jobless claims and ISM non-manufacturing are released Thursday, and Friday is all about August's employment report.

Investors will also be watching the G-20 finance ministers as they gather Friday in London, ahead of the G-20 meeting in Pittsburgh later in the month.

Oil Drill

Oil was up 1.6 percent for the week at $72.74 per barrel. The October natural gas contract fell 6 percent for the week to $3.033 per million BTUs.

"I think we're poised to break out," said M.F. Global senior vice president John Kilduff. "I think oil's run at $75 last week was a probe at what's going to be a new higher range for prices. What will help that will be continued weakness of the dollar. Even if we get just an okay reading on the unemployment numbers on Friday, that could be enough to propel this higher."

Kilduff said natural gas, which recovered some of its losses in the past week, should remain under pressure because of the supply dynamics.